Depreciation Recapture Rental Property Guide

May 21st 2024
Rental property owners can deduct depreciation from their taxes, which allows them to account for the natural loss in value of the home over time. This deduction helps reduce taxable income and can result in significant tax savings. However, there's a catch: when you sell the property, the IRS may require you to repay some of those tax savings through a process called depreciation recapture.

In this article, we will explain what depreciation recapture is, how it works, and what rental property owners need to be aware of when selling their property.

hash-markTable of Contents

What Is Rental Property Depreciation Recapture?
How Does Depreciation Work on Rental Property?
How To Calculate Depreciation Recapture on Rental Property
Depreciation Recapture Example
How To Avoid Depreciation Recapture
Depreciation Recapture Bottom Line

hash-markWhat Is Rental Property Depreciation Recapture?

Depreciation recapture is when the IRS reviews the sale of an investment property to get back some of the tax deductions you claimed for its depreciation. If they determine the deductions you claimed were too high for the rental property, they will hit you with a recapture penalty.

When a rental property is sold, the IRS will want to see whether the amount you wrote off on your taxes is roughly equal to the actual loss in value that the property experienced. They set a standard by which every real estate investor can use to estimate depreciation for tax purposes. However, that doesn’t mean that the figure is accurate for every property. 

Tracking Actual Deprecation

Actual depreciation is difficult to track until you sell the home because it’s dependent on several factors, including:

  • The condition of the property when purchased
  • The quality and frequency of maintenance and repairs
  • Changes in the real estate market
  • The location of the property and neighborhood developments
  • The length of time the property is held as a rental 
  • The types of tenants and their impact on the property’s condition
  • Natural wear and tear over time
  • Any improvements or renovations made to the property

For instance, if you have one tenant who stays for five years and is very responsible, the property may suffer far less damage than if you get a new tenant every year, and each does a bit more damage to the property.

Depreciation Recapture by the IRS

When you sell the property, the IRS will look at your profits and determine whether or not the amount you wrote off due to depreciation was commiserated with the actual decrease in value. If you wrote off more than you actually lost, the IRS will assess a tax to “recapture” some of that lost revenue, ensuring fair taxation on your property investment.

It's essential to keep accurate records of depreciation and consult with a tax professional to navigate this process effectively.

hash-markHow Does Depreciation Work on Rental Property?

Depreciation is not calculated based on the market value of a property – it is determined based on the cost basis. The cost basis is determined by adding up the property’s purchase price minus the land (because land does not depreciate), any money spent improving the home, and certain qualified closing costs.

Qualified closing costs include things like property taxes, recording fees, title fees, and any debts you assume on behalf of the borrower. You would then total up all those expenses and write off 100% of the cost basis over the recovery period set by the IRS. Currently, the recovery period for residential rental property is 27.5 years, which comes out to about 3.636% per year (100%/27.5)

So, the higher the cost basis, the more you can write off. That 27.5 years is more of a general estimate of a property's average lifespan, which is used as a benchmark for accounting purposes. Therefore, you may write off more than the property depreciates, which is when the IRS will want to recapture some of that money.

hash-markHow to Calculate Depreciation Recapture on Rental Property

  1. Determine Your Initial Cost Basis
  2. Calculate Your Adjusted Cost Basis
  3. Calculate the Realized Gain
  4. Multiply the Gain By the Recapture Tax Rate

1. Determine Your Initial Cost Basis

The first step in calculating depreciation recapture is determining how much you wrote off over the years. To do so, find your original cost basis, which can be done by adding up the price you paid for the property, the cost of any improvements, and any eligible closing costs, then subtract out the value of the land itself.

You would then multiply that by 3.636% (or whatever yearly percentage you used to depreciate) and the number of years you owned the property. This will tell you how much you wrote off on your taxes due to depreciation.

2. Calculate Your Adjusted Cost Basis

Next, you’ll calculate your adjusted cost basis and compare it to the recent sales price. To determine the depreciated cost basis, you take the original purchase price and subtract the depreciated value defined in the previous step. This will, in theory, tell you how much the property should now be worth due to depreciation. 

3. Calculate the Realized Gain

To calculate the realized gain, you would remove the recent sale price from the adjusted cost basis to determine how much you profited. If the sales price exceeds the adjusted cost by a significant margin, you will have to pay a tax.

Depreciation tax rates are based on the amount of realized gains and are generally assessed as ordinary income; however, they cap out at 25%. So, if you’re in the higher earning brackets, you won’t pay more than that.

4. Multiply the Gain by the Recapture Tax Rate

The recapture tax rate is usually taxed at 25%, which you will multiply by the amount of your depreciated value. Luckily, the IRS won’t ask for all the money back, but they will ask for a portion to make up for the years of tax deductions.

Remember that the remaining gain will also be subject to capital gains tax, which is either 0%, 15%, or 20%, depending on how much you made and how you choose to file.

hash-markDepreciation Recapture Example

To make it easier to wrap your head around this process, let’s take a look at an example. Say you purchased a property for $200,000 that sits on a $40,000 plot of land. You also made about $50,000 worth of improvements and paid $10,000 in closing costs.

Your initial cost basis would look like this:

(purchase price – land value) + improvements + closing costs = ($200,000 - $40,000) + $50,000 + $10,000 = $220,000

Say you owned the rental for ten years and depreciated the property at the standard 3.636% each year.

Your depreciated value would look like this:

Cost basis x depreciation rate x number of years = $220,000 x 0.03636 x 10 = $79,992

That means you could save close to $80,000 by depreciating the property for all those years.

But say you end up selling the property for $300,000, which is substantially more than you paid. You would then subtract the depreciated value from that figure to determine your realized gain.

300,000 - $79,992 = $220,008. Because your gain is so large, the IRS will want to recapture some of that money and tax 25% of the depreciated value.

$79,992 x 0.25% = $19,998

So, you may end up owing the IRS close to $20,000, in addition to what you also owe in capital gains tax.

hash-markHow to Avoid Depreciation Recapture

  1. Use a 1031 Exchange
  2. Turn the Property Into Your Primary Residence
  3. Leave the Property to Your Heirs

Most investors don’t want to pay this high tax because it will reduce their profits. So, they look for ways to avoid paying this additional fee. The most common way is through a 1031 exchange. 

1. Use a 1031 Exchange

Section 1031 of the Internal Revenue Code allows investors to defer capital gains taxes and other federal income liabilities – including depreciation recapture – when they purchase another property of a similar value.

This is known as a 1031 exchange. So, if you sell your rental property, then turn around and use the funds to purchase another property worth a similar amount, you don’t have to pay depreciation recapture or capital gains tax.

2. Turn the Property Into Your Primary Residence

Another strategy is to turn it into a primary residence. You can avoid paying capital gains tax on the home by using it as a primary residence for a few years. But you will still eventually be on the hook for depreciation recapture if you ultimately sell. 

3. Leave the Property to Your Heirs

You could also avoid selling the property and leave it to your heirs when you die. Heirs do not pay depreciation recapture or capital gains tax on inherited property. Instead, the cost basis will be stepped up to the current value, which effectively resets the depreciation clock.

hash-markDepreciation Recapture Bottom Line

Depreciation is a valuable tool that can help investors save tens or even hundreds of thousands of dollars on rental property. However, it’s also essential to keep track of how much you’re writing off and not to get carried away. The IRS is generous in allowing investors this deduction; however, they aren’t that generous. 

When you eventually go to sell the property, they will want to reclaim a portion of the deduction if it’s clear that your profits exceeded what you wrote off. So be prepared to pay some of this money back or speak to a tax professional to find a way to avoid recapture.